Structured Products

There’s lots of talk about commodities, of the price of crude oil rising one day and falling the next, or how China is hoarding industrial metals like copper or aluminum, but few practical solutions an investor can rely on to efficiently invest in commodities.

Whatever the reason behind the nominal price variations, unbiased advice proposing real solutions about investing in commodities is even scarcer. Most of the time, bankers propose products that are based on the Goldman Sachs Commodity Index (GSCI), or the Dow Jones AIG index (DJAIG), both of which have changed ownership recently. Goldman sold the GSCI to S&P, who rebranded it S&PGSCI, and UBS bought the DJAIG and rebranded it DJUBS. Changing the name did not improve the performance of either index, as the investment methodology remained the same: through front-months investments, which is often a disadvantage for the investor.

For those not familiar with the matter, here is a short explanation about how commodity investments work. Since most commodities cannot be physically held, investments have to be made through futures. Futures are an agreement between a buyer and a seller to purchase, respectively to sell, a given quantity of goods at an agreed price at a predetermined date in the future. Hence, futures expire after a certain time. It's usually not practical for a private investor to invest in futures,, beacuse if an expiry date is missed (say you are on holiday), then you will actually get the commodity delivered and nobody would like to get 200 tons of soybeans delivered in a silo located in North Dakota / USA. That's why investment banks have created commodity indices; they do not miss a delivery date and handle the investments in the commodity futures. In order to stay invested in the commodity without having to hold it physically, the expiring futures have to be rolled into a new future contract.

Now, the new contract must not necessarily have the same price than the expiring one, but may be either more expensive or cheaper. If more expensive, fewer contracts can be bought with the money generated by the sale of the expiring one. When the market is in such a situation, it is said to be in contango. The performance of the investment will be lower than the performance of the spot price of the commodity. The reverse is true for a market where the expiring month is worth less than the new one: the performance of the investment will be higher than the performance of the spot return; the market is said to be in backwardation. Markets in contango provide roll losses, while backwardated markets produce roll gains. However, the shape of a futures curve is by no means a good indication at which price the market will actually trade in the future!

On average, most commodity markets are trading rather in contango, especially precious metals, Natural gas and agricultural commodities. The performance of indices like S&PGSCI or DJUBS will suffer accordingly. Yet these indices are still widely in use, despite the fact that technologically more advanced commodity indices have been developed. Goldman developed the GSCI Enhanced index and UBS the CMCI (which stands for Constant Maturity Commodity Index). Both new indices feature a better average performance with the same volatility than the old ones.

I strongly encourage investments in indices of the second generation versus those of the first one. Practically every bank has its own set: JPMorgan launched its JPMCCI index, BNP Paribas the DCI, Deutsche Bank the Optimum Yield and Mean Reversing indices, etc. The list of all available indices is too long to be listed here, but there’s about 20 pages of additional information on commodity investments in the book “How to Invest in Structured Products”.

One good thing to remember if you’re bullish on a certain commodity, say crude oil, is that you’ll have to be more bullish than the forward curve (calculated using the futures available) implies. In other words, if the spot crude oil is trading at 80.- and you think it’s going to go up to 100.- within six months time, but the 6-month future is already trading at 105.-, there’s a good chance that your investment will have a negative performance, even though crude oil would rise! It would have to rise by more than USD 25.- for you to make a profit.

The difficulty lies in finding the right index for a given market situation and your expected scenario for the commodity you’re looking at. Of course, every bank is going to claim that their index is better and will outperform its competitors; and of course, every bank is wrong. Selecting the best index will precisely depend on the market conditions and your goals. If the market is backwardated and you expect it to stay that way, front-month indices will in fact perform well. Unfortunately, that doesn’t happen too often and the more difficult situation of contangoed markets has to be contended with. That’s when you are better off with second-generation indices like the CMCI index.

In any case, you cannot invest directly in an index, but one practical solution is to select an index certificate, also known under the appellation ‘tracker certificate’, that reflects the performance of the commodity index you have chosen. To finish, here are a few recommendations when investing in commodities:

• When considering an investment in commodities, determine first if the market is trading in contango or in backwardation. Then select the appropriate investment type.
• For a market trading in contango, choose a second-generation index that spreads or optimizes your investment on the futures “curve”.
• For a market trading in backwardation, choose a first-generation index that invests in front-months, provided that the backwardation starts right away. More often than not, the backwardation starts only a few months in the future, and the front-month trades in contango. In any case, avoid the S&PGSCI; it is said to be arbitraged by professionals who know at which dates the index and the products based on it roll their contracts.
• If you invest in first-generation index-linked products, watch the market; a backwardated curve may change in a contangoed one.
• Avoid complex products, like barrier worst-of reverse convertibles on three commodities (the classic is gold / crude oil / natural gas). They seldom perform well and the risk an investor takes is often underestimated.